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February 26, 2009

A Congressional Pledge to Preserve 401(k)s, Despite Their Flaws

Congress begins hearings on how to fix 401(k), other retirement vehicles; hears from Bogle, Alicia Munnell

Launching the first in a series of hearings on the retirement system--particularly the 401(k)--Rep. George Miller (D-California), chairman of the House Labor and Education Committee, said February 24 that while 401(k)s in their current form will not provide sufficient retirement security for the vast majority of Americans, 401(k) plans, nonetheless, must be "preserved and strengthened" in the short-term.

"The current economic crisis has exposed deep flaws in our retirement system," Miller said. "For too many Americans, 401(k) plans have become little more than a high-stakes crap shoot. If you didn't take your retirement savings out of the market before the crash, you are likely to take years to recoup your losses, if at all."

Strengthening the 401(k) system means rooting out hidden fees and conflicts of interest. In the last Congress, Miller proposed a bill that would require disclosure of 401(k) fees. "Wall Street opposed it," he said. "The ferocity of Wall Street's response to simple fee disclosure leads me to believe that they do not want 401(k) account holders to find out the billions they skim from Americans' hard-earned savings." All signs point to another such fee disclosure bill being introduced in this Congress, said ranking member Howard McKeon (R-California).

The Committee turned to its panel of witnesses for suggestions on how to fix the retirement planning system. John Bogle, founder and former CEO of Vanguard, suggested in his testimony that a single defined contribution plan for tax-deferred retirement savings be available to all Americans (with a maximum annual contribution limit), consolidating today's traditional retirement plans--DC plans, IRAs, Roth IRAs, 401(k) plans, 403(b) plans, and the federal Thrift Savings Plan. He also said an annuity option "to minimize longevity risk" should be provided in 401(k) plans, and that the fiduciary standard of care that plan sponsors are held to should be extended to all investment managers.

Bogle also echoed Miller's sentiment that high fees are indeed a big problem in 401(k) plans. He suggested all fund options available in 401(k) plans be tied to a market index. "The average equity fund carries an annual expense ratio of about 1.3% per year, or about 0.80% when weighted by fund assets. But that is only part of the cost," Bogle said. "Mutual funds also incur substantial transaction costs, reflecting the rapid turnover of their investment portfolios. Last year, the average actively managed fund had a turnover rate of an astonishing 96%. Even if weighted by asset size, the turnover rate is still a shocking--if slightly less shocking--65%." Admittedly, he continued, "the costs of this portfolio turnover cannot be measured with precision. But it is reasonable to assume that trading activity by funds adds costs of 0.5% to 1.0% to the expense ratio. So the all-in costs of fund investing (excluding sales loads, which are generally waived for large retirement accounts) can run from, say 1.5% to 2.3% per year." By contrast, he said, "low-cost market index funds have expense ratios as low as 0.10%, with transaction costs that are close to zero."

Alicia Munnell, director of the Center for Retirement Research at Boston College, told the committee in her testimony that "Even before the financial crisis, we have been concerned about the ability of 401(k) plans to provide secure retirement income." Evidence indicates, she said, "that people make mistakes at every step along the way. They don't join the plan, they don't contribute enough; they don't diversify their holdings; they over-invest in company stock; they take out money when they switch jobs; and they don't annuitize at retirement." She said that an annuity should be a default option in a 401(k) plan so that participants could choose to opt out. "People hate annuities," she said.

Dean Baker, co-director of the Center for Economic and Policy Research, told the committee that the collapse of the housing bubble, coupled with the plunge in the stock market, "has exposed the gross inadequacy of our system of retirement income." He suggested allowing Americans to contribute to a government-run pension system that would provide a modest guaranteed rate of return. "The system would be a universal system like Social Security, however, it would be voluntary," he said. "To try to maintain high rates of enrollment, there can be a default contribution from all workers of 3%, up to a modest level, such as $1,000 a year. Workers could be allowed to contribute some additional amount, for example an additional $1,000 per year, that would also earn them the same guaranteed rate of return."